What is Buffett formula?

Buffett uses the average rate of return on equity and average retention ratio (1 - average payout ratio) to calculate the sustainable growth rate [ ROE * ( 1 - payout ratio)]. The sustainable growth rate is used to calculate the book value per share in year 10 [BVPS ((1 + sustainable growth rate )^10)].

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Finding Stocks the Warren Buffett Way

Part 4: Is The Price is Right?

T

he price that you pay for a stock determines the rate of return-the higher the initial price, the lower the overall return. The lower the initial price paid, the higher the return. Buffett first picks the business, and then lets the price of the company determine when to purchase the firm. The goal is to buy an excellent business at a price that makes business sense. Valuation equates a company's stock price to a relative benchmark. A $500 dollar per share stock may be cheap, while a $2 per share stock may be expensive. Buffett uses a number of different methods to evaluate share price. Three techniques are highlighted in the book with specific examples. Buffett prefers to concentrate his investments in a few strong companies that are priced well. He feels that diversification is performed by investors to protect themselves from their stupidity. Earnings Yield Buffett treats earnings per share as the return on his investment, much like how a business owner views these types of profits. Buffett likes to compute the earnings yield (earnings per share divided by share price) because it presents a rate of return that can be compared quickly to other investments. Buffett goes as far as to view stocks as bonds with variable yields, and their yields equate to the firm's underlying earnings. The analysis is completely dependent upon the predictability and stability of the earnings, which explains the emphasis on earnings strength within the preliminary screens. Buffett likes to compare the company earnings yield to the long-term government bond yield. An earnings yield near the government bond yield is considered attractive. The bond interest is cash in hand but it is static, while the earnings of Nike should grow over time and push the stock price up. Historical Earnings Growth Another approach Buffett uses is to project the annual compound rate of return based on historical earnings per share increases. For example, take company in which current earnings per share are $2.77 and earnings per share have increased at a compound annual growth rate of 18.9% over the last seven years. If earnings per share increase for the next 10 years at this same growth rate of 18.9%, earnings per share in year 10 will be $15.64. [$2.77 * ((1 + 0.189)^10)]. This estimated earnings per share figure can then be multiplied by the company's historical average price-earnings ratio of 14.0 to provide an estimate of price [$15.64 * 14.0=$218.96]. If dividends are paid, an estimate of the amount of dividends paid over the 10-year period should also be added to the year 10 price [$218.96 + $13.32 = $232.28]. Once this future price is estimated, projected rates of return can be determined over the 10-year period based on the current selling price of the stock. Buffett requires a return of at least 15%. For our example, comparing the projected total gain of $232.28 to the current price of $48.25 leads projected rate of return of 17.0% [($232.28/$48.25) ^ (1/10) - 1]. Our first table lists the stocks passing the consumer monopoly screen that have a projected rate of return of 15% based upon historical earnings growth model.

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Sustainable Growth The third approach detailed in "Buffettology" is based upon the sustainable growth rate model. Buffett uses the average rate of return on equity and average retention ratio (1 - average payout ratio) to calculate the sustainable growth rate [ ROE * ( 1 - payout ratio)]. The sustainable growth rate is used to calculate the book value per share in year 10 [BVPS ((1 + sustainable growth rate )^10)]. Earnings per share can be estimated in year 10 by multiplying the average return on equity by the projected book value per share [ROE * BVPS]. To estimate the future price, you multiply the earnings by the average price-earnings ratio [EPS * P/E]. If dividends are paid, they can be added to the projected price to compute the total gain. For example, a company would have a sustainable growth rate of 19.2% if its average ROE was 22.8%, and average payout ratio was 15.9% [22.8% * (1 - 0.159)]. Thus, its current book value per share of $11.38 should grow at this rate to roughly $65.90 in 10 years [$11.38 * ((1 + 0.192)^10)]. If return on equity remains 22.8% in the tenth year, earnings per share that year would be $15.03 [ 0.228 * $65.90]. The estimated earnings per share can then be multiplied by the average price-earnings ratio of 14.0 to project the price of $210.42 [$15.03 * 14.0]. Since dividends are paid, use an estimate of the amount of dividends paid over the 10-year period to project the rate of return of 16.5% [(($210.42 + $12.71)/ $48.25) ^ (1/10) - 1]. The final Buffett screen establishes a minimum projected return from the sustainable growth rate model of 15%. A critical aspect to analysis is determining whether the companies will continue their past pattern of growth and profitability.

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Conclusion Warren Buffett's approach identifies "excellent" businesses based on the prospects for the industry and the ability of management to exploit opportunities for the ultimate benefit of shareholders. He then waits for the share price to reach a level that would provide him with a desired long-term rate of return. The approach makes use of "folly and discipline": the discipline of the investor to identify excellent businesses and wait for the folly of the market to buy these businesses at attractive prices. Most investors have little trouble understanding Buffett's philosophy. The approach encompasses many widely held investment principles. Its successful implementation is dependent upon the dedication of the investor to learn and follow the principles. For individual investors who want to duplicate the process, it requires a considerable amount of time, effort, and judgment in perusing a firm's financial statements, annual reports, and other information sources to thoroughly analyze the business and quality of management. It also requires patience, waiting for the right price once a prospective business has been identified, and the ability to stick to the approach during times of market volatility. But for individual investors willing to do the considerable homework involved, the Buffett approach offers a proven path to investment value.

home.csulb.edu - Finding Stocks the Warren Buffett Way

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